Wednesday, 13 November 2013

How to be a New Keynesian and an Old Keynesian at the same time

A recurring theme in economics blogs, particularly those that
tend to be disparaging of mainstream Keynesian theory, is that
Keynesians like to be New Keynesian (NK) when talking about theory, but Old
Keynesian (OK) when talking about policy. John Cochrane has recently made a similar observation, which is picked up by Megan McArdle. To take just one
example of this alleged sin, in the basic New Keynesian theory Ricardian
Equivalence holds (see below), so a tax financed stimulus should be as
effective as a debt financed stimulus, yet Keynesians always seem to prefer debt
financed stimulus.

The difference between Old and New that Cochrane focuses on
relates to models of consumption. In the first year textbook OK model,
consumption just depends on current income. The coefficient on current income is something like 0.7, which gives rise to a significant
multiplier: give these consumers more to spend, and the additional spending
will itself generate more output, which leads to yet more income, and so the
impact of any stimulus gets multiplied up.

Basic NK models employ the construct of the (possibly infinitely
lived) intertemporal consumer. To explain, these consumers look at the present
value of their expected lifetime income, and the income of their descendents if
they care about them (hence infinitely lived). This has two implications.
First, temporary shocks to current income will have very little impact on NK
consumption (it is a drop in the ocean of lifetime income). The marginal
propensity to consume out of that temporary income (mpc) is near zero, so no
multiplier on that account. Second, a tax cut today means tax increases
tomorrow, leaving the present value of lifetime post-tax income unchanged, so
NK consumers just save a tax cut (Ricardian Equivalence), whereas OK consumers
spend most of it. However NK consumers are sensitive to the real interest rate,
so if higher output today leads to higher inflation but the nominal interest
rate remains unchanged, then you get a multiplier of sorts because NK consumers
react to lower real interest rates by spending more.

So far, so different. But the NK consumption model assumes that
agents can borrow whatever they need to borrow. There are good theoretical
reasons why that is unlikely to be true (e.g. asymmetric information), and even
better empirical evidence that it is not. Empirical studies that look for
‘natural experiments’, where agents obtain an unexpected increase in post-tax
income which is likely to be temporary, typically find a mpc of around a third
(even for non-durables), rather than almost zero as the basic intertemporal
model would predict. (For just one recent example: Consumer Spending and the
Economic Stimulus Payments of 2008, by Parker, Souleles, Johnson, and
McClelland, American Economic Review 2013, 103(6): 2530–2553.)

So if mainstream Keynesian theory wants a more realistic
model of consumption, it often uses the (admittedly crude) device of assuming
the economy contains two types of consumer: the unconstrained intertemporal
type and the credit constrained type. A credit constrained consumer that
receives additional income could consume all of that additional income, so
their mpc out of current income is one. [1] That credit constrained consumer is
therefore rather Old Keynesian in character. But there are also plenty of
unconstrained consumers around (e.g. savers) who are able to behave like
intertemporal maximisers, so by including both types of consumer in one model
you get a hybrid OK/NK economy.

So it is perfectly possible to be an Old Keynesian and a New
Keynesian at the same time, using this hybrid model. It may not be a
particularly elegant model, and the microfoundations can be a bit rough, but
plenty of papers have been published along these lines. It is a lot more
realistic than either the simple NK or OK alternatives. It explains why you
might favour a bond financed stimulus over the tax financed alternative,
because there are plenty of credit constrained consumers around who are the
opposite of Ricardian.[2]

You can make the same point about one of the other key
differences between OK and NK: the Phillips curve. The New Keynesian Phillips
curve relates inflation to expected inflation next period, and assumes rational
expectations, while a more traditional Phillips curve combined with adaptive
expectations relates current inflation to past inflation. While I do not think
you will find many economists using the OK Phillips curve on its own nowadays,
you will find many (including this lot) using a hybrid that combines the
two. The theoretical reasons for doing so are not that clear, but there is plenty
of evidence that seems to support this hybrid structure. So once again it makes
sense to be both OK and NK when giving policy advice.

Neither story is as exciting as the idea that New Keynesians
are really closet Old Keynesians, who only pay lip service to New Keynesian
theory to gain academic respectability. Instead it’s a story of how mainstream
Keynesian economists try to adapt their models to be more consistent with the
real world. How dull, boring and inelegant is that!

[1] I say ‘could’ here, because if the increase in income lasts
for less time than the expected credit constraint, then smoothing still
applies, and the mpc will be less than one.

[2] My own view is that the mpc out of temporary income is also
significant because of precautionary savings: see the paper by Carroll
described here.

14 comments:

This is a very enlightening article, Professor Wren-Lewis. Your illuminating explanations of OK and NK and of how economists reconcile the two is much more valuable to me than the recent posts by DeLong and Krugman--I find their responses to Cochrane to be more to the wonkish "gotcha" side relative to your delightfully understandable rumination on the substance of Cochrane's argument.

It is a fact that there are many new Keynesian models in the literature which have Ricardian equivalence ( say Smetts-Wouters). I hope no one takes the policy implications of such grossly unrealistic models seriously. It may be rude to call the analysis of such models insincere lip service to applied math dressed up as economics. However I see no other way to describe the phenomenon.

Also you and Cochrane know more about this than I do, but I know of no evidence of superiority of the hybrid model over a model of complete myopia and habit formation. It is certainly true that all of the classical (e.g. Noted ny Friedman) evidence for the PIH fits a model of myopia and habit formation just as well. Since NK DSGE models all include habit formation (to fit the otherwise excess smoothness) the question of what of any empirical vlue is added by forward looking expectations is to my limited knowledge open.

The fact that no one uses adaptive expectations is an appeal to authority not evidence. It is simply a fact that the variation TIPs breakevens can be explained in part assuming adaptive expectations R squared of 0.5 is the crazy period 2008-9 is excluded. I contrast thre is no hint of any trace of any explanatory power of forward looking expectations for the very boring reason that achieved inflation rates to maturity of the bonds have hppened to be almost constant since the introduction of TIPs (about 2.5%).

Your post suggests that the NK glass is half full with useful insights from both NK and OK models. I am honestly not aware of significant evidnce that the NK glass isn't almost exactly empty.

'So consider two hypotheses. One — which Cochrane appears to believe — is that being inside the Beltway has rotted Janet’s and Olivier’s brains, not to mention that of all their researchers, causing them to revert to primitive concepts that “everyone” knows are false. The other — which is what I hear from young economists — is that there is an equilibrium business cycle claque in academic macroeconomics that has in effect blockaded the journals to anyone trying to publish models and evidence that stress the demand side.'

Does this apply only to US economic journals, or to ones in the UK as well?

It seems to me that once you take on board issues like credit constraints and agents with limited horizons, you're not being both NK and OK, you're just being OK. I don't think that OK ever said that current income was the only thing that determined consumption, merely that it would have some effect.

But labels shouldn't be the issue. The question is do we think that, in the real world, these factors will lead to there being some kind of multiplier effect via income. If we do, then we should be suspicious of any model that purports to demonstrate that there is no such effect by assuming away the things that cause it.

I entirely agree.New Keynesians make me think of secret agents who believe they spy for one side, when they're in fact manipulated by the other side.When there are theoretical reasons why assumptions are "unlikely to be true and even better empirical evidence that [they are] not", such assumptions should be left to the use of the Chicago boys. They're doing economics for the sake of the art, not for answering crucial policy questions.Cochrane may not be so wrong about New Keynesians, but he just misses the fact that his critic applies to NeoClassical economists as well.

A lot of non-economists like myself will be asking is there any room for context in this discussion and economies with different types of labour markets and financial systems. When we talk about "The coefficient on current income is something like ...", would this equally true in Japan in 2013 as the US in 1935? It just might be that the answers lie in the context - Keynes or Friedman or Cochrane could be completely right or not at all depending on it.

Simon: fair enough. But let me give you another very big difference between Old and New Keynesian models in their fiscal policy recommendations.

Assume there is an increased desire to save, that lowers the natural rate of interest, and that the central bank is unable or unwilling to lower the market rate of interest to match it. What is the policy recommendation for government spending if you want to increase the natural rate of interest to prevent a recession?

Old Keynesian models say: increase the level of government spending.

New Keynesian models say: reduce the expected growth rate of government spending.

That is a substantive difference. (And I think that making half the agents hand-to-mouthers won't change that result, though I'm not 100% sure on that.)

A keen implication is that distribution matters for demand. If income is transferred from those with little unmet demand to those who have large unmet demand, then net demand will increase. Wealthy special interests who cannot get past the idea of "zero sum" resent the redistribution as a dead loss. However, if the transfer increases demand and increases production (and wealth) in the system, then a transfer can be win-win. Many of the arguments against stimulus assume no resulting increase in output and denounce redistribution as zero sum in spite of overwhelming evidence to the contrary.

Forgive a simple question/observation..but isn't a critical aspect of Keyne's original work (maybe Original rather than Old) that Capital flows had to constrained..? And isn't the entire issue surrounding the Euro/EZ expirement, that it was precisely the surge in Capital Inflows that destabilized the Money/Fiscal relationship? And that this applies as much coming as going out?

Prof Simon and the above commentators all assume that Keynsianism in its broadest sense includes just two possibilities: funding stimulus via borrowing and via tax.In fact Keynes was quite happy with a third alternative: funding stimulus by simply printing money. See 5th paragraph here:

http://www.scribd.com/doc/33886843/Keynes-NYT-Dec-31-1933

Certainly to impart stimulus by extra spending, and then negate or partially negate that stimulus by borrowing or raising taxes is on the face of it bizarre. That strikes me as making as much sense as throwing dirt over your car before cleaning it – or maybe AFTER cleaning it.